Is Interest Expense an Operating Expense? Why This Matters for Financial Metrics

Growing companies often discover their financial metrics tell conflicting stories about performance. Operating income looks strong, but net income disappoints. EBITDA suggests healthy cash generation, yet the bank balance tells a different story. The confusion typically traces back to one line item that sits in an unusual place: interest expense.

Interest expense is classified as a non-operating expense under U.S. GAAP standards, so it appears below operating income on income statements rather than within the operating expenses section. This placement matters because it determines whether key performance metrics accurately reflect operational performance versus financing decisions.

This guide covers what interest expense actually is, why its classification as non-operating shapes financial metrics, and how to handle it correctly in accounting systems.

What is interest expense?

Interest expense represents the cost of borrowing money, calculated based on outstanding debt balances and applicable interest rates. To calculate interest expense, multiply the outstanding loan balance by the interest rate, then divide by the number of periods. Common sources include term loans, lines of credit, business credit cards, equipment financing, commercial mortgages, and SBA loans.

Interest expense differs fundamentally from loan principal payments. When you make a $5,000 monthly loan payment, only a portion represents interest expense that appears on the income statement. The remainder pays down principal, which affects the balance sheet but doesn't flow through the P&L. Under accrual accounting, interest expense is recognized as it accrues based on loan terms, while principal payments simply reduce outstanding debt balances.

This distinction matters for financial statement presentation and performance measurement. Interest expense reduces net income and appears as a non-operating item on income statements, while principal payments shift balance sheet accounts without affecting the P&L. This separation allows operating income, EBITDA, and operating margin to reflect core business performance independently of financing decisions.

Is interest expense an operating expense?

Interest expense is a non-operating expense, not an operating expense. Under GAAP standards governed by SEC Regulation S-X Rule 5-03 and ASC 225, interest expense appears below operating income on income statements because it relates to financing activities rather than core business operations.

Income statements follow a standard sequence: revenue minus cost of goods sold equals gross profit, then operating expenses are subtracted to arrive at operating income. After operating income, other income and expenses including interest expense appear, leading to income before taxes, then tax expense, and finally net income.

This structure ensures operating income reflects core business profitability before considering financing choices. The placement below operating income maintains clear separation between operational performance and financing decisions, allowing stakeholders to evaluate business quality independent of capital structure.

What counts as operating expenses?

Operating expenses directly support revenue generation and daily business operations, which explains why interest expense sits outside this category.

Operating expenses include:

• Salaries and wages for employees who deliver products or services
• Rent and utilities for facilities
• Marketing and advertising to attract customers
• Business insurance coverage
• Office supplies and equipment
• Professional fees for legal and accounting services
• Software subscriptions
• Travel costs for customer meetings and business development

Interest expense sits outside this category because it represents a financing decision rather than an operational one. Two companies with identical operations can have completely different interest expenses based purely on whether they funded growth through debt or equity.

Why do you need to know the difference between operating vs. non-operating expenses?

Classifying interest expense as non-operating creates several advantages for performance evaluation, progress tracking, and competitive benchmarking:

• Fair competitive benchmarking: Operating income remains comparable across companies at different leverage levels. You can evaluate a debt-free competitor and a leveraged competitor on equal operational footing, assessing core business performance without financing structure obscuring the comparison.
• Consistent performance tracking: Operating metrics stay clean as debt levels change. When you pay down debt or take on new financing, operating income and margin continue reflecting operational improvements without financing decisions creating artificial swings.
• Clear management accountability: Operational teams get evaluated on metrics they can influence through pricing strategy, cost management, efficiency improvements, and market expansion. They're not penalized for corporate financing decisions made at the board level.
• Accurate business valuation: Investors and acquirers can assess core business profitability independent of capital structure. EBITDA shows cash-generating power before debt payments, helping stakeholders understand fundamental capacity regardless of financing choices.

These advantages compound as organizations grow and capital structures become more complex. Operating margin (operating income ÷ revenue) becomes a pure efficiency benchmark you can compare across industries, whether evaluating a debt-free software company against a heavily leveraged manufacturer.

What are the most common challenges with interest expense?

These patterns show up repeatedly across companies at different stages, and recognizing them helps avoid material financial reporting issues before they compound.

Inconsistent cash flow statement classification

Entities may have a choice to classify interest payments on loans as either cash flows from financing activities or operating activities, but this choice must be applied consistently. Many non-finance managers don't realize there's a policy choice involved and classify interest payments differently from period to period.

This distorts cash flow analysis and makes it impossible to track operational cash generation trends reliably. Companies need to establish a documented accounting policy for interest payment classification and apply it consistently every reporting period.

Capitalized interest handling

When companies build or develop significant assets, the interest on loans funding that construction gets added to the asset's cost rather than expensed immediately. The amount reported as interest expense doesn't include the capitalized portion, but the cash outflow still occurs and must be properly classified in the cash flow statement.

This creates a critical distinction: while capitalized interest doesn't reduce operating income during the construction period, the actual cash payment must be correctly categorized (typically as an investing activity rather than operating activity) to prevent misrepresenting operational cash flow.

Personal and business interest expenses mixed together

In owner-operated businesses, boundaries between personal and business accounts become blurred. Mixing personal and business transactions quickly creates confusion. This applies directly to interest expense when managers pay business loan interest from personal accounts or vice versa, creating misstated financial statements and potential tax reporting problems.

Miscategorizing different types of interest expenses

Operators code credit card interest as "bank fees" or classify financing charges as "loan principal" without understanding the accounting distinctions. Poor bookkeeping practices increase interest costs because misclassification prevents proper monitoring of borrowing costs. Charts of accounts need specific categories for different interest expense types with clear guidance on when to use each one.

Reconciling interest expense with cash payments

Interest that accrues in December but isn't paid until January can create timing differences between P&Ls and bank statements under accrual accounting, but not under cash-basis accounting. Under accrual accounting, businesses must record interest expense as it's incurred, even if they haven't paid it during the current reporting period.

Without regular reconciliation procedures connecting accrued interest (income statement) to interest paid (cash flow statement), companies can't anticipate large interest payments or catch genuine errors when they occur.

Best practices for managing interest expense and other non-operating expenses

Strong interest expense management starts with proper categorization, ratio monitoring, and consistent documentation. These practices ensure financial statements accurately reflect business performance and maintain the separation between operational and financing activities.

Set up proper chart of accounts categorization

In QuickBooks, navigate to Bookkeeping, select Chart of Accounts, click New, choose Account Type: Expenses, and select Detail Type: Other Miscellaneous Expense. Name it clearly as "Interest Expense" to ensure it appears under the "other expenses" section of the P&L, in the non-operating section below the operating income line.

Xero and NetSuite follow similar principles, requiring setup of expense accounts that feed into the non-operating section of income statements.

Track key financial health ratios

Monitor the ratios that boards, investors, and lenders use to evaluate whether interest expense levels are sustainable. Calculate Interest Coverage Ratio by dividing EBIT by interest expense. Commercial lenders typically look for ratios between 2.5x and 3.0x as a safer buffer, while ratios below 1.5x generally indicate higher financial risk.

For Debt Service Coverage Ratio, divide net operating income by total debt service (principal plus interest). Lenders typically require 1.2 to 1.25 as minimum acceptable levels. Debt-to-EBITDA shows how many years of earnings would be required to pay off total debt, with many financial advisors suggesting companies maintain ratios below 3x for healthy operations.

Prepare board-ready financial summaries

Create a simple summary table showing Interest Coverage Ratio, DSCR, and Debt-to-EBITDA alongside industry benchmarks. Show trends over time because improving or stable metrics demonstrate healthy financial management. Many finance professionals recommend maintaining Interest Coverage above 2.5x, DSCR above 1.25x, and keeping Debt-to-EBITDA below 3.0 to show strong financial health.

Be ready to explain any declining trends and present action plans if metrics approach concerning thresholds, particularly if Interest Coverage drops below 2.5, DSCR falls below 1.25, or Debt-to-EBITDA exceeds 4-5. Compare ratios to industry peers when possible since capital-intensive industries naturally operate with different leverage profiles than asset-light businesses.

Maintain strict account separation

Maintain strict separation between personal and business accounts to ensure all business interest expense gets paid from business accounts and properly documented. This becomes particularly important for owner-operated businesses where owners might have personally guaranteed business loans. Establish policies prohibiting the use of business accounts for personal transactions and vice versa.

Document your accounting policies clearly

Document accounting policies for interest expense treatment as a non-operating expense on income statements, particularly around cash flow statement classification and handling of capitalized interest during major projects.

According to GAAP standards, interest expense is classified separately from operating expenses that appears below operating income on income statements. This ensures metrics like operating income, EBITDA, and operating margin accurately reflect core business performance independent of financing decisions.

Categorize interest expense in the "Other Expenses" or "Non-Operating Expenses" section of accounting software (such as the "Other Miscellaneous Expense" account type in QuickBooks, or the dedicated non-operating section in Xero and NetSuite). Share these documented policies with anyone who codes expenses to ensure consistent application, as consistency across reporting periods matters more than any single classification approach.

Transition from cash to accrual accounting smoothly

During a company's growth from cash-basis to accrual accounting, work closely with CFOs, controllers, or external accounting advisors to understand how interest expense treatment changes. Focus on the distinction that under accrual accounting, interest is recorded when incurred (not when paid), and adjust internal processes and cash flow monitoring accordingly.

Monitor key ratios including Interest Coverage Ratio (maintain above 2.5x), DSCR (maintain above 1.25x), and Debt-to-EBITDA (keep below 3.0x) as financial reports are prepared for board and investor discussions.

Establish monthly reconciliation procedures

Set up monthly reconciliation procedures for all loan accounts, connecting interest accrued on income statements with interest paid on cash flow statements. Multi-step income statements separate expenses, income, gains, and losses into two categories: operating and non-operating, ensuring interest expense correctly appears as a non-operating expense below operating income.

Document significant timing differences between accrual and payment, particularly the distinction between when interest is recorded on P&Ls versus when it's actually paid. This will help board members and investors understand any apparent discrepancies between income statement figures and cash flow statement activity.

FAQs about interest expense

Can interest expense ever be considered an operating expense?

Under U.S. GAAP, interest expense is typically presented as a non-operating item below operating income on the income statement, but GAAP doesn't explicitly require this classification or placement in all cases. This classification is mandated by SEC Regulation S-X Rule 5-03 because interest relates to financing activities rather than core business operations. While interest paid may appear in operating activities on cash flow statements, it remains non-operating on income statements.

What's the difference between interest expense and bank fees?

Bank fees for transaction processing, monthly account maintenance, and wire transfers are typically operating expenses because they relate to day-to-day business activities. Interest expense on loans, credit cards, and lines of credit is non-operating because it represents the cost of financing rather than operational costs.

Non-operating expenses generally appear near the bottom of a company's income statement after operating expenses, while bank fees appear within the operating expenses section.

How does cash basis versus accrual accounting affect interest expense?

Under cash-basis accounting, interest expense is recorded only when payment is actually made. Accrual accounting records interest as it accumulates based on loan terms, regardless of payment timing.

If a company has a quarterly loan payment due December 31 but pays January 7, cash-basis accounting records the entire amount in January while accrual-basis spreads the expense across October, November, and December as interest accrues monthly.

What interest coverage ratio should you target for healthy financial management?

For healthy financial management, many finance professionals recommend targeting an Interest Coverage Ratio of at least 2.5x, with 3 to 5x representing generally comfortable coverage and above 5x indicating a strong position. This metric measures how easily a company can pay interest on outstanding debts using operating earnings (EBIT ÷ Interest Expense).

Ratios below 2.5x typically raise red flags for lenders and investors, while ratios of 3 or higher demonstrate comfortable cushion to handle interest obligations even if earnings decline. Combined with complementary metrics like DSCR (above 1.25x) and Debt-to-EBITDA (below 3x), a healthy Interest Coverage Ratio helps ensure companies maintain sustainable leverage and financial flexibility.